EMPLOYEES WHO accumulate significant company stock can end up with a problem, though not necessarily a bad one: concentrated stock holdings. When these employees retire, their challenge is to sell those shares in a way that maximizes their value—taking into account the share price, dividends and taxes. One strategy: Utilize covered calls.
Selling a concentrated stock position can take many years because of tax considerations or restrictions on selling. For example, if appreciated shares are held in a regular taxable account, you might want to cap annual sales to limit your adjusted gross income and hence the tax rate you pay. If the shares are held in an IRA or 401(k), they can be sold without any immediate tax consequences—but, before doing so, you’d want to check whether you can make use of the net unrealized appreciation strategy.
I’m no options expert. But I and several of my friends have utilized covered calls to enhance income without taking great risk. Let’s say you have 10,000 company shares that you would like to divest over a 10-year period. That means you intend to sell 1,000 shares per year. In this case, you have at least 1,000 shares on which you can comfortably sell covered calls, knowing you wouldn’t be bothered if the shares were called away.
My first recommendation: Learn the basics of covered calls. When you sell a call, the buyer purchases the right to buy the stock in the future at a specified share (or “strike”) price. In return, you—the seller—receive extra income in the form of a call premium. Covered means that you, as the seller, own the shares on which you’re selling the calls and hence you’ll have no trouble delivering the stock, if the call option is exercised. Want to learn more? The Options Industry Council, Investopedia and many brokerage firm websites are all potential resources.
Selling call options generates extra income. The disadvantage is that upside profits are capped at the strike price and further price appreciation is forfeited to the buyer. Since markets go up over the long term—often in big jumps—call options fundamentally limit upside stock returns. Sellers of covered calls also suffer any share price decline, marginally offset by the call premium.
These disadvantages are hugely diminished for anyone stuck with large numbers of company shares. You have the downside risk, no matter what you do. You want to sell some shares anyway—and preferably when the stock price is headed up. Lastly, even if you give up upside price appreciation on a few calls, you still retain upside on your larger block of remaining shares. By selling a covered call, you either pocket some extra income when the share price doesn’t rise or you sell shares at a higher price, plus you receive the call premium. Either outcome should be favorable.
My next recommendation: Play around with an options calculator to get a sense for the returns you might capture with covered calls. Calculators provide the returns on two scenarios—the stock being called away or the call option expiring unexercised—and take into account the time value of money, dividends and commissions.
You’ll probably need to sign some waivers with your brokerage firm before you’re allowed to trade options. Since covered calls are a relatively conservative trading approach, the financial requirements are less rigorous than full-blown options trading.
The final step: Dive into the deep end and sell one or two calls. Each call is for 100 shares. If you intend to sell 1,000 shares this year, you can “play” with up to 10 covered calls with little risk of a horrible outcome. Here, based on my experience, are eight pointers:
John Yeigh is an engineer with an MBA in finance. He retired in 2017 after 40 years in the oil industry, where he helped negotiate financial details for multi-billion-dollar international projects. His previous articles include Nothing to Chance, Hers, His and Ours and Unloaded.